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STATE OF AFFAIRS
Right before the Easter holiday weekend, we received new clear confirmation that central banks across the globe, and in particular the US Fed, are in command. The US Fed, backed up by and in cooperation with the US Treasury, decided to increase the scope and size of the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). Also, other programs were launched in a bid to provide credit to small- and medium-size businesses as well as state/local governments. Funding for the SMCCF was raised by the Treasury. Equity capital rose from USD 10 billion to USD 25 billion. The surprise was the scope, as the leverage on equity will be 10 times for investment grade (IG) corporate bonds (excluding financials) and seven times for bonds rated lower than IG. Thus, in addition to US IG corporate bonds and IG ETFs, the Fed can purchase BB-rated bonds from issuers recently downgraded to fallen angel status. Prior to March 22, the Fed could only buy IG bonds. The Fed can now also buy high yield (HY) ETFs as long as they have a high percentage of IG bonds. The Ford Motor Company, with its debt burden of USD 48 billion, is a big winner. Others include the iShares iBoxx High Yield Corporate Bond ETF, as it jumped an impressive 6.55% on Thursday April 9. This US HY ETF is recording a year-to-date loss of just 5.05% versus a decline of 9.21% for the iBoxx USD Liquid High Yield index. The ETF went from trading at a large discount during the sell-off to trading at a premium last week! On March 23, both instruments had hit a low of -21%.
On this side of the Atlantic, the ECB’s claims of flexibility became more evident. As all components of the purchase programs are gaining traction, we observe high flexibility in capital key considerations. Over the month of March, the ECB purchased an extra EUR 6 billion in Italian government bonds (known as BTPs) versus what was allowed by its capital key. At the same time, the central bank’s purchases of German bunds were close to EUR 7 billion lower. Such deviations might continue for months, even for years if necessary. This enables the ECB to cap Italian 10-year rates to a maximum level of 1.60% to 1.70%, protecting Italian authorities from rising funding costs. This is also buying time for the European Monetary Union (EMU) until it can evolve towards a proper monetary union with a correct level of fiscal transfers.
Yes, we believe that an important first step has been taken. EU Finance Ministers agreed on a EUR 540 billion package of measures to buffer the economic fallout of the health crisis. This includes EUR 100 billion joint employment insurance, EUR 200 billion of European Investment Bank (EIB) funding to provide liquidity to companies and EUR 240 billion from the European Stability Mechanism without a strict set of conditions attached. The Ministers will also work on a Recovery Fund that could total EUR 500 billion. This fund, which might be agreed for the second half of 2020, might become the first mutualized funding instrument within the Eurozone.
The deflation, disinflation, inflation debate is raging. There is broad agreement that inflation indicators will get hit over the next 12 or even 24 months. However, we observe some disparity of opinions regarding inflation outcomes beyond five years. Professional economists are leaning towards a deflationary/disinflationary outcome. Market participants are more worried. Market-based inflation expectations have seen a solid recovery after hitting lows due to deflation fears on March 9. The reason for the tentative rebound in inflation expectations is technical, but there is also a positioning angle to this. The technical reason lies in the fact that most inflation-linked bonds have an inflation floor. Investors will be paid at par, or 100%, at redemption even after years of deflation. The positioning angle comes with the cheap optionality that one owns when buying inflation-linked bonds at current and still attractive break-even rates. The combined effect of the factors outlined below leave us long on inflation expectations.
Central banks will remain loyal to and support symmetric inflation objectives of around 2.00%.
The disinflationary impulse of globalization is fading.
The global policy response is basically reflationary. Inflation history shows that surprises are likely.
Demand and supply recovery times are highly uncertain but will exhibit asynchronous pattern.
The labour factor, wages, might not be punished too hard. The atypical nature of this recession will require efforts by capital and labour. Given the bail-out of capital, business owners might not take advantage as much of the unemployment backdrop during salary negotiations and offerings. Governmental labour bodies might also keep a close eye on this.
US 10- and 30-year rates respectively rose by about 7 basis points (bp) and 12 bp over the shortened Easter week, closing at 72 bp and 1.34%. In contrast, US 10-year real rates dropped 3 bp to -51 bp, while US 30-year real rates dropped 3 bp to -12 bp. It seems that rising inflation expectations are being priced in, as reflected in the real yield curve’s slide into negative territory. With unlimited Fed quantitative easing, we maintain our implicit “Yield Curve Control” call. US real rates have room to fall further when we see that UK 10-year real rates sit at -2.62% or Swedish 10-year inflation-linked bonds are valued at -1.20%.
German 10-year rates closed at -35 bp, up 10 bp over the week. We expect more intra-EMU rate convergence in the coming weeks, as market participants will increasingly anticipate common funding. Even if that funding takes longer than expected. In the period briefly preceding the creation of the EMU during the 90s, French 10-year government bonds (also known as OATs) and German 10-year bunds traded flat. The current 10-year bund-OAT spread of 44 bp could disappear again. Spanish and Portuguese government bonds are offering attractive yields to international investors after EUR-hedging. Italy is topping the charts in that regard. However, EMU break-up fears must first vanish completely before international investors start buying into Italian BTPs. For some, last week’s breakthrough might be a good enough reason to initiate long positions in attractive BBB country spread risk.
On Thursday April 9, EUR IG corporate bonds had their best 1-day return since the Great Financial Crisis. The EUR iBoxx All Maturities Index added 90 bp and eased the year-to-date pain to a smaller 5.06% decline. IG spreads dropped to 210 bp. “Fear of missing out” action was visible across credit markets. As inventories of sell-side credit market makers are thinning due to central bank demand and the temporary drop in primary issuance, the secondary market became buoyant after real money investors pounced on available offers. Still, as constructive as we are on spreads, we underscore the importance of the damage inflicted over the past month. Recovery will take time. It is reassuring however that credit spread buffers have increased, providing more protection in case rates go back up.
EUR HY credit ended the week on a strong note. We welcome increased liquidity support programs from governments and supranational institutions (EIB) and believe that one should even start integrating the prospect of a broadening of the Corporate Sector Purchase Program so that BB-rated HY bonds are included. The ECB might consider following the Fed in its support of “fallen angels” since the beginning of the crisis. The (European) HY market will remain polarized between the winners (telecoms, healthcare, food staples and, to a certain extent, packaging) and the losers (travel, gaming, specialty retail, automotive). The wide range of default scenarios over the next years might put a brake on the aggressive tightening of spreads over the past week. Spreads in EUR HY started around 790 bp and finished around 690 bp. The pace of this rebound is not sustainable, as worsening fundamentals will impact the weakest balance sheets. However, credit line support should help avoid worst-case default scenarios. At this juncture, HY credit spreads reflect market anticipation of a sharp, but short downturn in economic activity.
Emerging bond markets consolidated further before the Easter break. Local currency spreads (GBI-EM Index) tightened by 15 bp to 470 bp. In hard currency debt, there was a rally going into the long weekend. Hard currency IG debt traded at 345 bp (-15 bp). Broad Hard Currency (EMBIG Index) tightened by 45 bp to 620 bp and Sub-Saharan Africa’s spreads in hard currency narrowed by 120 bp to 890 bp.
Emerging market currencies posted their best weekly performances since early February. Currencies that had been hit the hardest are now the best performers. They include the Mexican Peso (+3.9%), Indonesian Rupiah (+3.6%), Hungarian Forint (+2.8%) and Brazilian Real (+2.0%) in EUR terms. In contrast, the Argentine Peso (-1.6%), Indian Rupee (-1.6%) and Turkish Lira (-1.2%), in EUR terms, were the worst performers.
The IMF announced that it will offer short-term USD loans to countries that do not hold enough US Treasuries to participate to the Fed program that allows foreign central banks to temporarily exchange US debt for USD liquidity. This could temper the USD shortage and improve liquidity conditions in the market. Also, the OPEC output cut should at least bring some temporary relief to oil-exporting emerging countries.
The question that remains on everyone’s mind is whether we will see another month of high level stress as in March. The answer will depend on potential lockdown extensions in the absence of a clear decline in infection growth rates. The more we postpone an initiation of “back-to-normal” procedures, the higher the probability that financial markets might relapse into erratic and highly volatile trading. The monetary backstop is reassuring for government and IG credit sectors. The HY sector is getting more attention, finally. Selling pressure might come from the equity sector given the uncertainty over future dividend pay-out ratios and longer-term earnings growth prospects.
In such an environment, discipline in portfolio construction is crucial. Sufficient allocation to US Treasuries and the US IG credit market is needed. Indeed, it enables you to benefit from the impressive Fed support as well as from the power of USD diversification. The USD remains the global reserve currency of choice and is benefiting from the strong flight-to-quality sentiment. Don’t leave the dollar-block currencies behind (AUD, NZD, CAD), as they tend to react positively to early growth normalization signals. Within the EMU, we believe that the risk/return ratio of Belgian, Spanish and Portuguese government bonds is adequate. Strong IG credit solutions will raise expected returns. We are also turning cautiously optimistic on emerging market government bonds, both in local and hard currency. Adding EUR HY and EUR convertible bonds to your fixed income allocation also increases the chances to capture recovery potential. However, adding at current levels requires a long-term investment horizon.